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The Calm Before the Storm - High Quality Credit Spreads

FICC Podcasts August 25, 2021
FICC Podcasts August 25, 2021

 

Dan Krieter and Dan Belton discuss credit spreads in the current directionless markets ahead of this week’s much awaited Jackson Hole Symposium. Other topics include coming changes at the Fed and expectations for financial regulation in 2022 and 2023.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter:

Hello, and welcome to Macro Horizons, high quality spreads for the week of August 25th, The Calm Before the Storm. I'm your host Dan Krieter, here with Dan Belton, as we discuss a few topics today, ranging from our expectations for the Jackson Hole meetings to a potential shakeup at the Fed come fall and what it may mean for credit and swap spreads going forward.

Dan Krieter:

Each week, we offer a view on credit spreads, ranging from the highest quality sectors such as agencies and SSAs to investment grade corporates. We also focus on US dollar swap spreads and all the factors that entails, including funding markets, cross currency markets, and the transition from LIBOR to SOFR.

Dan Krieter:

The topics that come up most frequently in conversations with clients and listeners form the basis for each episode. So please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or emailed directly at dan.krieter@bmo.com. We value and greatly appreciate your input.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Dan Krieter:

Well, Dan, the term summer markets is never more applicable than it has been these past couple of weeks now, with issuance falling off a cliff and secondary market volumes extremely, extremely light as we'd expect, of course, for the time of the year. It just seems like everything's in a holding pattern, and that includes credit spreads.

Dan Belton:

Yeah. Credit spreads since the middle of July have traded in a pretty tight range. So in the ICE BAML index, IG index, spreads have been between 91 and 95 basis points for the better part of the last six weeks or so. You alluded to the light volumes and secondary. Last week we saw the lightest Monday, Tuesday, and Thursday volumes that we've seen all year. Wednesday was the second lightest for any Wednesday of the year. And Friday was the third lightest Friday for this year. So yeah, we're in very much of a holding pattern in credit spreads. There's just little conviction and the market is, I think, waiting for this Jackson Hole meeting.

Dan Krieter:

Yeah. So lethargy obviously makes sense, particularly ahead of the Jackson hole meeting. But I do want to highlight that because even though we didn't see spreads move much last week, there was at least one trend I thought worth noting coming from last week's price action. And that's that spreads did appear to be reacting to some news around tapering.

Dan Krieter:

And if true, that comes as a surprise to us, right? Because our expectation was the tapering was pretty much priced in and that really any changes to timing or pace of tapering, unless they were truly drastic, we didn't think it would matter much. Nevertheless, last week, if you looked at the major moves in spreads, we saw widening last week in the middle of the week, that coincided almost perfectly with the release of the FOMC minutes, that read as a bit more hawkish, suggesting the potential for even a September announcement and tapering.

Dan Krieter:

And then Friday, we had commentary from traditionally a hawk, Fed President Kaplan who implied that the timeline for tapering could be pushed out as a result of the Delta variant and some renewed fears of weakness. And then we saw credit spreads trade firmly, probably the most firmly they did all week last week on Friday, right after Kaplan's comments. Which came as a deviation from sort of the parade of Fed speakers in the preceding weeks that were all pointing to tapering being on schedule here.

Dan Krieter:

So it did seem like the market was reacting to tapering news. And, you know, again, to hammer home the point of that being surprising, particularly with the Fed taking the important step this time of explicitly divorcing the timeline for tapering from the timeline for hiking, they've said, doesn't matter when we start tapering asset purchases, it has absolutely no impact on the timeline for liftoff. And yet it does seem like we're seeing spreads react. Dan, what's your read on that?

Dan Belton:

Yeah, I agree. It's somewhat surprising that we've seen a reaction in markets around this talk about tapering. Now, I don't want to make too much of an issue out of just a basis point or two of narrowing and widening in credit spreads, but it is somewhat surprising.

Dan Belton:

I think if we were to see the tapering timeline delayed by a month, or let's call it a meeting, a month and a half, maybe that is worth about a basis point in credit spreads. It still doesn't change my view that we're not going to get anything resembling the backup we saw in credit spreads around the taper tantrum in 2013. But it is moderately surprising that the timing of tapering, whether it came in September or now it's looking more likely that an announcement is going to come in November, that does matter somewhat for credit investors.

Dan Krieter:

Yeah, and I'm with you on that. I'm not convinced that this is a tapering thing. I think it could just be coincidental. But the timing of these moves is suspicious enough to at least highlight it. Because it could mean that there might be some more volatility later this week surrounding the Jackson Hole meetings than we would've thought heading into it.

Dan Krieter:

So I think maybe it's worth spending just a couple of minutes here talking about Jackson Hole and what our expectations are for it. And I guess we have to start with what the market is expecting from Jackson Hole. Because it does seem like the consensus that has bubbled to the surface here in the past week is that Jackson Hole is going to be mostly a non-event. It seems that we've all taken on this attitude that the Fed does not want to front run the September FOMC meeting, which happens on September 22nd. So you have a pretty big window there.

Dan Krieter:

But still, apparently the Fed does not want to take away from the September FOMC. So people expected nothing. But I would say to the extent that people are expecting anything, they're likely expecting more dovishness.

Dan Belton:

Yeah, I agree. I think the main surprise that we could get from Jackson Hole would be some guidance that a tapering announcement can come in September. So you mentioned the September 22nd FOMC meeting. Now, the blackout period typically begins about 10 days before that.

Dan Belton:

So we would likely need to see some guidance coming between now and call it September 12th or so indicating that the Fed is on track to announced tapering in September. Because I don't think it's been messaged nearly enough yet. And it would probably spook markets if it wasn't really telegraphed at the Jackson hall meetings this week or shortly thereafter.

Dan Belton:

So my base case is that Chair Powell and other Fed speakers this week, we'll reiterate what they've been saying at, and since the July FOMC meeting, which is that it's likely that a taper announcement is coming this year, but probably not at the September meeting.

Dan Krieter:

Yeah, I'm with you that if the Fed were to actually taper in September, it would need to be messaged at Jackson Hole for sure. And I don't think that's going to happen. So if we look at the balance of risk coming out of Jackson Hole, if we accept that the market is seemingly more sensitive to tapering than we thought, it seems like what we're saying for Jackson Hole is that we're in alignment with the market, this isn't going to be a big deal.

Dan Krieter:

I don't think the Fed is going to take any drastic measures and push tapering off into say early 2022 or something like that. So if the base case is that the Fed is just going to keep the timeline for November or December intact, I think that's what's going to happen.

Dan Krieter:

I guess if we had to pick a risk to the meeting, like what's more likely, spreads narrow or widened coming off the meeting? I personally feel like it's widening. I don't see a scenario where the Fed is going to end up being more dovish than the market expects. I don't think there's any chance the Fed is going to take 2021 out of the timeline for tapering.

Dan Krieter:

So if that's a 0% chance, well, I don't think there's much chance [inaudible 00:07:05] September, I think it's greater than 0%. So I would say the risk from the Jacksonville meeting is toward wider spreads, but that's it. I don't expect much reaction. Where do you fall?

Dan Belton:

Yeah. If we're taking unchanged out of the equation, then I think it's more likely that spreads move wider on the back of Jackson Hole. I think the only real risk to spreads moving narrower would be if the Fed really played up the threat of the Delta variant and what it implied for economic growth and the necessity of continued monetary accommodation.

Dan Belton:

But even now that I mention that, that scenario could cause under-performance in risk assets just through the negative growth outlook that would ensue. But I don't think that's likely, I think if spreads were to react significantly, I think it would be in response to messaging that a September taper is still a very likely outcome from the meeting.

Dan Krieter:

Yeah, okay. Well, it sounds like we're in agreement there. And before moving away from the FOMC, Dan, I thought it might be interesting to talk a little bit about some potential changes coming up for the Fed in the months ahead. None larger, of course, than the chair of the FOMC himself, Jerome Powell's term scheduled to end in February of 2022. Of course, he's up for another term if that's the direction that the administration goes. Dan, what's your read on Powell so far?

Dan Belton:

I think as of about a month ago, I would've given him probably something like 50% odds of being reappointed. More recently, it seems like things have pointed towards a reappointment for Chair Powell. He's gotten an endorsement from Treasury Secretary Yellen, which I think is not necessarily surprising, but the fact that she reportedly did opine on his reappointment certainly bodes well for him.

Dan Belton:

So I would expect that he's going to be reappointed, although it certainly isn't a foregone conclusion at this point. Either way, Chair Powell is a pretty dovish Fed chair. I think if he were to be replaced, it would be by another dove, likely Lael Brainard is the front runner for that post if he does not get reappointed.

Dan Krieter:

That's the way I've been approaching it really, is that whether or not Powell returns, I don't think this storyline is going to have much of an impact to financial markets. Because like you said, if Powell is out, it will be another dove. It's not going to be some new Chairman that comes in and immediately reverses course to something much more hawkish.

Dan Krieter:

So from where I was sitting, regardless of the chairman of the path of monetary policy was not likely to change. I guess, if forced to pick, I think I would say that a Powell renomination makes the most sense, particularly with, you know, the relationship that we at least think he has with Janet Yellen and her support for him.

Dan Krieter:

But I think from the market's perspective, it doesn't really matter too much either way. It was certainly worth talking about. But I do want to talk about something that I think matters potentially a lot more, which is the end of Randal Quarles' term as Vice Chair of Supervision.

Dan Krieter:

We know that that post is obviously the one that oversees regulation from the Fed's perspective, and regulation is set to be a very important storyline going forward. I can think of just off the top of my head, three major storylines on the regulation front that could be coming in the next 12 months and maybe arguably could have happened already were it not for the lame duck status of Quarles and how that may impact whether or not to push through regulation at this point.

Dan Krieter:

But those three things are the SLR, the potential for increased regulation or oversight over non-bank financial intermediaries, you know, 'shadow banks.' That one's a bit more complicated because there is limits to the Fed oversight there. So you have coordination with FSOC and things like that. But I still would think that the Fed and particularly the Vice Chair of Supervision is heavily involved in those conversations.

Dan Krieter:

And the third one is the potential for more money market reform, which we've obviously heard a lot about. All three of these things the Fed has talked about a lot in the press conferences following FOMC meetings for the past year. So regulation's coming, and we're going to have a new Vice Chair of Supervision. I think we know that at this point.

Dan Krieter:

So Dan, has the end of Quarles' term entered into your market outlook at all? Or I guess even more importantly, do you think that the market has been paying attention to it?

Dan Belton:

It doesn't seem like it's been discussed as much as I would expect it to be. Quarles' term ends on October 13th of this year. So it's a pretty near term consideration, at least the way that I'm thinking about it. He could of course stay on the Fed board if he so chose, but his term as the Vice Chair for Supervision ends in just about seven weeks.

Dan Belton:

So we will see a change in the regulatory environment, even if that's going to be a longer-term consideration, something that happens gradually after his term ends. Eventually, once Biden has a Vice Chair for Supervision in place, we're going to see some more hawkish regulation.

Dan Belton:

So I think with respect to SLR, it makes it less likely that we're going to see something more bank friendly that excludes Treasuries from the denominator of the ratio, if we see a change to that rule at all. Money market reform, I think it's very likely that something a little bit more stringent becomes proposed with the new Chair for Supervision. But maybe the reason that this hasn't been more at the forefront of market discussions is just because it's going to be a longer term process and something that is more a 2022 or even 2023 story.

Dan Krieter:

I was going to say the same thing. It's not something that's going to, suddenly October 14th, now we're going to have a bunch of new regulation. It's a very longterm storyline. But I think it is one that we have to pay close attention to.

Dan Krieter:

Because I think you look at the standard rule making process for regulation at the Fed. Typically, there's a notice for proposed rule making, which is released for comment. The comment period would then be at least 30 days, often longer than that. Then there is a lag where the Fed has to digest the market's comments before a final rule is issued.

Dan Krieter:

Well, clearly if that's the timeline for a new Fed rulemaking of regulation, that's going to take, you know, three months, probably, at least at a minimum. With Quarles' term ending in October, that's probably been a constraint on any regulation being passed for, arguably, months now, as we just await a new Vice Chair of Supervision.

Dan Krieter:

And so it's still going to take a long time, but I agree with you that once Biden installs a new Vice Chair of Supervision, there is some regulatory things that need to happen. And there is arguably going to be a more hawkish slant to it.

Dan Krieter:

I think what you said about the SLR hit the nail right on the head. It won't be as bank friendly. We've already heard some of the more Democratic members of Congress criticizing the Fed back in the March cycle where the SLR temporary exemption expired. We saw some criticism coming the Fed's way from the Senators talking about it almost as a "bank bailout.". And I don't agree with that. But you know, someone that Biden appoints would ostensibly not favor such a broad sweeping exemption for banks, maybe it just comes into reserves at that point. And if we get a weaker SLR, that definitely removes some of our rationale that was behind the idea that [inaudible 00:13:38] would widen as a result of the SLR.

Dan Krieter:

And then I think you also alluded to money market reform, and that's a big one. I think money market reform is almost definitely coming. The Fed has seemingly pointed the finger at the money markets, not just for what happened in 2008, but also the liquidity event of 2020. Money markets are again shouldering at least some of the blame, even if not as much has happened in the financial crisis.

Dan Krieter:

And we can just riff on this for a second, but I think the money market reform is pretty significant out there. I mean, we could be looking at the potential end of prime funds or prime funds at least as we know them right now, which has obvious ramifications for things like unsecured wholesale funding for banks, for LIBOR potentially to the extent that LIBOR is still a rate that measures bank funding. We would expect that to go up, and see LIBOR OAS spreads increase arguably significantly, which would certainly be a widener for front end swap spreads.

Dan Krieter:

Another thing, talking about the transition away from LIBOR is the selection between BSBY and SOFR. Well BSBY is still reliant on those transactions. If we see prime funds go away, then we have BSBY not really based on anything. So that's a very, very key risk for BSBY there that could lead to some market participants not really wanting to adopt it. I mean, it does seem like enthusiasm for BSBY has been dropping here recently.

Dan Belton:

Yeah, I certainly agree. And I think given that BSBY... Like LIBOR is really predicated upon heavy unsecured funding volumes. Any changes in regulations as they relate to money market funds or prime funds specifically could pose a real structural threat to BSBY as a rate, and certainly as it relates to becoming a replacement for LIBOR.

Dan Krieter:

Well Dan, we've sort of been all over the place today. I think with thin markets and not a lot going on, we got a chance to talk about some of these broader themes, changes at the FOMC and stuff like that. The title of today's episode was The Calm Before the Storm. And the idea behind that was that we had [inaudible 00:15:28] markets now before the storm of what's going to be September supply. We only got to whatever minute it is now, 15 plus, before we talked about that. We won't get into depth on it today. That will be the focus of both our written weekly on Friday, and we will talk about it in detail next Wednesday on our podcast edition, looking at our expectations for September supply.

Dan Krieter:

So that was the idea of The Calm Before the Storm, the storm being supply we all know September is going to be quite heavy and we expect some more interesting storylines to start emerging from the market in that timeframe.

Dan Krieter:

But I guess high level for today, we can wrap it up just by saying, I think our view on the market for people that listen to us or read our written work, it's not really changed. We were expecting for a long time a technically driven widening in July and August, and we've gotten that. I guess the question for you, Dan, is has this been a technical move or is there more underneath it?

Dan Belton:

Yeah, I think it's been partly technical and it's also been partly a reflection of a reversal of some of the reopening trades. So we looked at the sectoral breakdown of credit spreads since the end of Q2. And the end of Q2 is when spreads hit their cyclical lows of about 80 basis points in the Bloomberg Barclays Index. Since then, spreads are about eight basis points wider. And this widening has been led by some of the higher beta sectors.

Dan Belton:

So for instance, leisure is the most exposed to a re-emergence of COVID lockdowns. Leisure's out 19 basis points since the end of June, far and away the worst-performing sector. And then we have insurance services, financial services, those are all pretty insulated from increased restrictions. Those have outperformed the broad index.

Dan Belton:

But there's been a lot of exceptions to this reversal of the reopening trade. For instance, you have basic industry, which is really predicated upon production, manufacturing, raw materials, things that are typically well correlated with economic reopening. That's only out five basis points since the beginning of the quarter. It's one of the better performing sectors in Q3.

Dan Belton:

So just on a whole, there's a positive correlation between sector betas and quarter to date spread changes. But it's far from one-to-one. The correlation coefficient is about 0.4, which to us suggests that it's largely a technically driven move, even though there is something to be said for a reversal of the reopening trade.

Dan Krieter:

Yeah, I think that's really interesting information, Dan. I like that. I still look at it as mostly a technically driven move, but obviously the proliferation of Delta certainly can't be ignored, and the under-performance some of those reopening sectors.

Dan Krieter:

But high level, was it enough for you to change your view? We've been calling for spreads in the second half of the year to return to historically low levels, maybe making new historical lows. Is that still your view?

Dan Belton:

I think spreads are going to continue to test historical lows. I'm still looking for about mid 70s in the Bloomberg Barclays Index. So right around to the historical lows. I'm not sure that we'll be able to break through those this year. And I think as we move into 2022, spreads are likely to find some headwinds with respect to Fed policy changing or at least expectations of this change in Fed policy. So I think mid 70s are just around historical lows is what I'm targeting for the end of the year. And then maybe some headwinds thereafter.

Dan Krieter:

Yeah, I'm right there with you. I think 75 is the low we've observed on the index in its history. I think that's a fair target for the end of the year. And obviously we'll see come September, with more liquidity, how that view evolves. So we're expecting the return of liquidity to result in spreads coming back narrower again, the reach for yield to be reignited or there would be more demand even despite the wider supply. But we'll start to get that hypothesis tested here pretty soon. I'm personally looking forward to it and we need some more issuance, huh, Dan?

Dan Belton:

Yeah, we do. I for one I'm ready for September.

Dan Krieter:

All right, everyone, enjoy the rest of the summer lightness here. And we'll be back next week with our forecast for corporate [inaudible 00:19:15] supply come September.

Dan Belton:

Thanks for listening.

Dan Belton:

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at daniel.belton@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including the FICC macro strategy group and BMO's marketing team. The show has been edited and produced by Puddle Creative.

Speaker 2:

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Speaker 2:

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Speaker 2:

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Speaker 2:

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Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD

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